The use of Enterprise Management Incentive (EMI) schemes is wide ranging and when they work properly they offer attractive tax breaks to the optionholders. However our experience from recent M&A transactions is that the existence or proposed implementation of EMI schemes often leads to issues that need resolving. The purpose of this note is to share with you some of these experiences to increase awareness of the possible pitfalls of EMI schemes.
Under rules introduced with effect from 6 April 2013, shares acquired as a result of the exercise of an EMI option will attract entrepreneurs' relief (subject to satisfying conditions). However where those options were issued and exercised prior to 6 April 2013, entrepreneurs' relief will not be available unless they give the holder more than 5% of the issued ordinary share capital and at least 5% of the votes.
This differential treatment of option holders could produce tax inequalities among selling shareholders. For example a shareholder holding 4.99% of the ordinary shares and voting rights will not qualify for entrepreneurs' relief if he acquired them from an old EMI option exercised before 6 April 2013. However, someone who exercises an EMI option now holding say 0.1% of the share capital will qualify for such relief. In such situations, the larger shareholders may want to consider other ways to compensate those individuals affected as quite often they will have been involved with the business for some time and will be disadvantaged compared to others who have contributed less to the growth of the business.
Entering into a share purchase agreement (SPA) is more often than not a "disqualifying event" for EMI purposes. This is not normally an issue where signing and completion occur simultaneously as EMI options are usually exercised immediately before completion. However, where the SPA is conditional (i.e. there is a period between signing and completion), one has to consider whether or not the conditions in the SPA are "conditions precedent" or "conditions subsequent".
If the SPA is a "conditions precedent" contract, the disqualifying event for EMI purposes takes place at completion and this normally does not create an issue. An example of a "conditions precedent" SPA is where completion is subject to the obtaining of a regulatory approval.
If on the other hand the SPA is a "conditions subsequent" contract, the disqualifying event occurs on signing and the EMI holder then has 90 days in which to exercise the option. An example of a "conditions subsequent" contract is where a regulatory approval is required, completion is conditional on approval but still goes ahead, and there is a right of rescission after completion if the approval is not obtained. However the EMI documentation may not allow for exercise until immediately before completion. If this is the case, the EMI holder either loses the EMI tax benefits or even worse the EMI options may lapse.
Where EMI options in the purchaser, target or any target group company are to be issued to employees immediately prior to sale of the target, it is essential to consider whether any of these companies is a party to any 50:50 joint venture. If it is, the EMI options issuing company will not be a qualifying company for EMI purposes and this will mean that it is unable to issue EMI options. If this situation arises, think about whether the shareholding ratio can be changed before the transaction takes place and/or the options are issued.
A cashless exercise is where an option holder exercises his options but does not physically pay the exercise price; it is instead deducted from the proceeds of sale of the shares.
Cashless exercise arrangements for EMI options are acceptable to HMRC provided they are allowed under the scheme rules.
However it is important that a mandatory cashless exercise should not be in place when the options are granted; the agreement should simply permit a suitable cashless exercise arrangement.
Therefore if the EMI documentation does not allow for a cashless exercise, there are really only a couple of routes open:
- Approach HMRC to agree that a cashless exercise will not cause problems for the EMI status of the options (although this may cause timing issues for a transaction); or
- The optionholders, if they do not have sufficient free capital, arrange short term funding for the option exercise price.
Neither of the above are perfect but if this is going to be a potential issue, it is best identified early so that the various options can be properly considered.